Is Government Involvement Really Necessary: Implications for Systemic Risk and Crop Reinsurance Contracts

Xiaoguang Feng and Dermot Hayes

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: Agriculture is subject to substantial systemic risk of crop yield losses due to widespread natural disasters. The systemic risk has been a major obstacle for the development of private crop insurance markets. Driven by spatially correlated weather events, crop losses are highly correlated within a certain area. As a result, the portfolio insurance risk associated with the crop losses has been raised far above what it would be if individual losses were independent, as proposed by Miranda and Glauber (1997). For example, Miranda and Glauber (1997) find that the portfolio risk faced by U.S. crop insurers is about ten times larger than that of conventional insurance lines. Large portfolio risk requires high premium rates to cover the cost of bearing the systemic portfolio risk unless the cost is subsidized. Some national governments, such as the U.S., are willing to provide subsidies and reinsurance for crop insurance policies so that they are affordable to farmers. In this way, the cost of bearing the systemic risk has been transferred to governments. For those countries where there are no government subsidies, private crop insurers would have to charge high premiums, in order to hold large enough reserves for the potential systemic loss or purchase expensive international reinsurance. In this way, the cost of bearing the systemic risk is actually passed onto farmers eventually. Consequently, farmers are either buying extremely expensive insurance to get insured, or being exposed to huge crop loss risks.

Date: 2014-10-01
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